Beware of bias

How you think when you invest and how to make better decisions

Much research has been undertaken regarding the biases which people have when making investment (and other) decisions. It’s important to know and understand them in order to avoid them – and the mistakes they engender – when making your own decisions.

We are all human beings and we have certain preferences. It’s very important to understand how we think and how we view certain things. How do we digest information and how do we let that influence us to make proper decisions and how that actually applies to investments?

One study posed questions to 300 fund managers to explore their behavioural attitude and how it manifests in their day-to-day living and how this impacts their investment decisions. For example one question was “Are you above-average at your job?” Some 74% said that they were … and that’s human nature! When someone asks you that kind of question, it’s unlikely that you’ll answer negatively about yourself or say you’re below average. People exaggerate their own abilities and their own success. This is what is referred to as over-optimism.

If we now apply this to investments or to financial planning, that is something that investors need to guard against. If they are over-optimistic or think they know more about something than the average person does, then whether it is picking a fund manager or making an investment, the danger is that they will have so much conviction that they have a blind spot for the potential risks that exist and they might not take the downside into account. To guard against being overly optimistic, you need to flip the coin several times, you need to look at your decision from all sides and all angles and make sure there isn’t a risk that you hadn’t seen.

This leads on to the second type of bias – confirmation bias – which is the tendency to look for information that agrees with what we already think. In this instance, 95% of the fund managers failed this question. What this means is that they were looking for things that support their decisions instead of looking at them objectively.

Say, for example, you need to make an investment decision regarding taking money offshore and the currency is starting to depreciate and you are losing out. This can cause pain and discomfort and, in such a situation, most people respond by looking for information that confirms or supports the decision that they made. They tend not to look at the other side of the debate but rather only looking for confirmation of the decision that has been made. And I think that is also very dangerous in terms of making investment decisions as well.

The next bias is anchoring. In this instance, recent experience will influence your thoughts and decisions. Anchoring is when we use irrelevant, possibly even subliminal inputs in making decisions. If, for example, you had experienced a severe bear market – as we did in 2008 – then that is what is in the back of your mind and you anchor to that kind of event and it then clouds your decision-making process. People may say, “Well, a bear market is not a very nice thing, I don’t want equity exposure ever again,” and then they get out of the markets and into something like cash. That, of course, is a recipe guaranteed to lose value over time as the after-tax returns from cash are very unlikely to match inflation.

The last point I’d like to touch on is Cognitive Reflection (CR) and decision-making. CR is the ability to discern between a gut response and to analyse and think a bit more carefully. There are two types of cognitive processes – those undertaken swiftly with little conscious deliberation and those that are slower and more considered. Research has found that people who score highly on Cognitive Reflection Tests have certain behavioural traits. For one, they tend to be more patient. They also tend to have a high risk appetite for gains, but they tend to be more risk averse on the downside.

This becomes apparent when the same outcome is framed in terms of the potential gains vs the potential losses. Framing refers to a situation whereby we fail to see through the way in which information is provided to us. For example, which investment option would you prefer:

The outcomes of Option A and Option B remain the same, but they are framed in a positive and negative way. Our decision regarding the preferred option is clouded by the way that we view the information presented.

The key is to be aware of your potential biases and blind spots when making investment decisions. It may be hard to sell a share at a 10% loss, or to want to lock in a 20% profit, but the market doesn’t care what you paid for a share. Your decision needs to be based on where it is likely to go from here. If it is likely to drop further, rather get out of it, even if it is at a loss. If it is likely to rise in future, hold onto it. Always look at the underlying value and base your decision on that.

This can require steely nerves and if it is challenging do keep a cool head, we should rather involve a financial partner who can walk with us so that when these kinds of thing happen we have a sounding board to reflect on logic and reasoning and what is appropriate at any given stage.

As human beings, we need to guard against behavioural biases. We need to challenge any view that we’ve got and be humble about the decisions that we make.